Monday, November 18, 2013

Several things worth reading that give tiny rays of hope that one day we might get some regulations with real teeth to reform the financial system.

First, some remarks by Kenneth C. Griffin, the founder and chief executive of Citadel, giving his views that the big banks should be broken up, or laws changed to encourage the flowering of smaller banks with competitive advantages on the local level (he mentions in particular putting caps on the size of deposits).

Second, an essay by law professor Peter Henning who is a specialist in financial fraud and enforcement. He gives a look at how developments such as derivatives and high frequency trading have created a host of opportunities for sophisticated market manipulation, but also how some recent legal changes have given regulators more power to pursue actions even if they cannot prove "intention to manipulate."

Third, an extended article looking at how things are developing with the so-called Volcker Rule that would, ostensibly, prohibit investment banks from trading on their own proprietary accounts. This gives a mixed message, actually, and it even seems that some of the regulators are part of the problem. Look at the second sentence below:

Gary Gensler,
head of the Commodity Futures Trading Commission, also wants to make it
harder for banks to disguise speculative wagers as permissible trading
done for customers, according to the officials briefed on the
discussions. Underscoring the tension, other regulators privately
groused that Mr. Gensler’s agency — which spent most of the last few
years completing dozens of other new rules under Dodd-Frank — was too
slow to raise concerns about the Volcker Rule.

Finally, a great speech by Elizabeth Warren on why Too Big To Fail remains a very serious prpoblem even five years after the worst moments of the crisis. Some excerpts below:

Thank you, Americans for Financial
Reform and the Roosevelt Institute for inviting me to speak today.
I’ve been working very closely with both AFR and Roosevelt for
years now, and I’m really delighted to be here.

It has been five years since the
financial crisis, but we all remember its darkest days. Credit dried
up. The stock market cratered. Historic institutions like Lehman
Brothers and Merrill Lynch were wiped out. There were legitimate
fears that our economy was tumbling over a cliff and that we were
heading into another Great Depression . We averted that grim outcome
, but the damage was staggering. A recent report by the Federal
Reserve Bank of Dallas estimated that the financial crisis cost us
upward of 14 trillion dollars — trillion, with a t. That’s
$120,000 for every American household — more than two years’
worth of income for the average family. Billions of dollars in
retirement savings disappeared . Millions of workers lost their jobs
and their sense of financial security. Entire communities were
devastated. And a Census Bureau study that came out just a couple
months ago shows that home ownership rates declined by 15 percent for
families with young children. The Crash of 2008 changed lives
forever.

In April 2011, after a two - year
bipartisan enquiry, the Senate Permanent Subcommittee on
Investigations released a 635 - page report that identified the
primary factors that led to the crisis. The list included high -
risk mortgage lending, inaccurate credit ratings, exotic financial
products , and, to top it all off, the repeated failure of regulators
to stop the madness. As Senator Tom Coburn, the Subcommittee’s
ranking member, said: “Blame for this mess lies everywhere from
federal regulators who cast a blind eye, Wall Street bankers who let
greed run wild, and members of Congress who failed to provide
oversight.” Even Jamie Dimon, the CEO of JPMorgan Chase, has
emphasized inadequate regulation as a source of the crisis. He wrote
this to his shareholders: “had there been stronger standards in
the mortgage markets, one huge cause of the recent crisis might have
been avoided. ”

The crash happened quickly and
dramatically, and it caught our nation and apparently even our
regulators by surprise. But don’t let that fool you. The causes of
the crisis were years in the making, and the warning signs were
everywhere. As many of you know, I spent most of my career studying
the growing economic pressures on middle class families — families
that worked hard and played by the rules but still can’t get ahead.
And I’ve also studied the financial services industry and how it
has developed over time. A generation ago, the price of financial
services — credit cards, checking accounts, mortgages, and
signature loans — was pretty easy to see. Both borrowers and
lenders understood the basic terms of the deal. But by the time the
financial crisis hit, a different form of pricing had emerged.
Lenders began to use a low advertised price on the front end to
entice customers, and then made their real money with fees and
charges and penalties and re - pricing in the fine print. Buyers
became less and less able to evaluate the risks of a financial
product, comparison shopping became almost impossible , and the
market became less efficient. Credit card companies took the lead,
with their contracts ballooning from a page and a half back in 1980
to more than 30 pages by the beginning of the 2000’s. And teaser -
rate credit cards — which advertised deceptively low interest rates
— paved the way for teaser - rate mortgages. When I worked to set
up the Consumer Financial Protection Bureau, I pushed hard for steps
that would increase transparency in the marketplace. The crisis began
one lousy mortgage at a time, and there is a lot we must do to make
sure there are never again so many lousy mortgages. CFPB made some
important steps in the right direction, and I think we’re a lot
safer than we were.

But what about the other causes of the
crisis ? … Where are we now, five years after the crisis hit and
three years after Dodd - Frank? I know there has been much discussion
today about a variety of issues, but I’d like to focus on one in
particular. Where are we now on the “Too Big to Fail” problem?
Where are we on making sure that the behemoth institutions on Wall
Street can’t bring down the economy with a wild gamble ? Where are
we in ending a system that lets investors and CEOs scoop up all the
profits in good times, but forces taxpayers to cover the losses in
bad times? After the crisis, there was a lot of discussion about how
Too Big to Fail distorted the marketplace, creating lower borrowing
costs for the largest institutions and competitive disadvantages for
smaller ones. There was talk about moral hazard and the dangers of
big banks getting a free, unwritten, government - guaranteed
insurance policy. Sure, there was talk, but look at what happened:
Today , the four biggest banks are 30% larger than they were five
years ago . And the five largest banks now hold more than half of the
total banking assets in the country. One study earlier this year
showed that the Too Big to Fail status is giving t he 10 biggest US
banks an annual taxpayer subsidy of $83 billion. Wow . Who would have
thought five years ago , after we witnessed firsthand the dangers of
an overly concentrated financial system, that the Too Big to Fail
problem would only have gotten worse?

We should not accept a financial system
that allows the biggest banks to emerge from a crisis in record -
setting shape while working Americans continue to struggle. And we
should not accept a regulatory system that is so besieged by
lobbyists for the big banks that it takes years to deliver rules and
then the rules that are delivered are often watered - down and
ineffective . What we need is a system that puts an end to the boom
and bust cycle. A system that recognizes we don’t grow this country
from the financial sector; we grow this country from the middle
class. Powerful interests will fight to hang on to every benefit and
subsidy they now enjoy . Even after exploiting consumers, larding
their books with excessive risk, and making bad bets that brought
down the economy and forced taxpayer bailouts, the big Wall Street
banks are not chastened . They have fought to delay and hamstring the
implementation of financial reform, and they will continue to fight
every inch of the way. That’s the battlefield. That’s what we’re
up against. But David beat Goliath with the establishment of CFPB
and, just a few months ago, with the confirmation of Rich Cordray.
David beat Goliath with the passage of Dodd - Frank. We did that
together – Americans for Financial Reform, the Roosevelt Institute,
and so many of you in this room. I am confident David can beat
Goliath on Too Big to Fail . We just have to pick up the slingshot
again.

Friday, November 15, 2013

I just happened across this interesting panel discussion from a couple years ago featuring a number of economists involved with the Rational Expectations movement, either as key proponents (Robert Lucas) or critics (Bob Shiller). A fascinating exchange comes late on when they discuss Jack Muth -- ostensibly the inventor of the idea, although others trace it back to an early paper of Herb Simon -- and Muth's later attitude on this assumption. It seems that Muth came to doubt the usefulness of the idea after he looked at the behaviour of some business firms and found that they didn't seem to follow the Rational Expectations paradigm at all. He thought, therefore, that it would make sense to employ some more plausible and realistic ideas about how people form expectations, and he pointed, even in the early 1980s, to the work of Kahneman and Tversky.

I'm just going to quote the extended exchange below, including a comment from Shiller who makes the fairly obvious point that if economics is about human behavior and how it influences economic outcomes, then there clearly ought to be a progressive interchange between psychology and economics, and from Lucas who, amazingly enough, seems to find this idea utterly abhorrent, apparently because it may spoil economics as a pure mathematical playground. That's my reading at least:

Lovell
I wish Jack Muth could be here to answer that question, but obviously he can’t because he died just as Hurricane Wilma was zeroing in on his home on the Florida Keys. But he did send me a letter in 1984. This was a letter in response to an earlier draft of that paper you are referring to. I sent Jack my paper with some trepidation because it was not encouraging to his theory. And much to my surprise, he wrote back. This was in October 1984. And he said, I came up with some conclusions similar to some of yours on the basis of forecasts of business activity compiled by the Bureau of Business Research at Pitt. [Letter Muth to Lovell (2 October 1984)] He had got hold of the data from five business firms, including expectations data, analyzed it, and found that the rational expectations model did not pass the empirical test.

He went on to say, “It is a little surprising that serious alternatives to rational expectations have never really been proposed. My original paper was largely a reaction against very näıve expectations hypotheses juxtaposed with highly rational decision-making behavior and seems to have been rather widely misinterpreted. Two directions seem to be worth exploring: (1) explaining why smoothing rules work and their limitations and (2) incorporating well known cognitive biases into expectations theory (Kahneman and Tversky). It was really incredible that so little has been done along these lines.”

Muth also said that his results showed that expectations were not in accordance with the facts about forecasts of demand and production. He then advanced an alternative to rational expectations. That alternative he called an “errors-in-the-variables” model. That is to say, it allowed the expectation error to be correlated with both the realization and the prediction. Muth found that his errors-in-variables model worked better than rational expectations or Mills’ implicit expectations, but it did not entirely pass the tests. In a shortened version of his paper published in the Eastern Economic Journal he reported,

“The results of the analysis do not support the hypotheses of the naive, exponential, extrapolative, regressive, or rational models. Only the expectations revision model used by Meiselman is consistently supported by the statistical results. . . . These conclusions should be regarded as highly tentative and only suggestive, however, because of the small number of firms studied. [Muth (1985, p. 200)]

Muth thought that we should not only have rational expectations, but if we’re going to have rational behavioral equations, then consistency requires that our model include rational expectations. But he was also interested in the results of people who do behavioral economics, which at that time was a very undeveloped area.

Hoover
Does anyone else want to comment on issue of testing rational expectations against alternatives and if it matters whether rational expectations stands up to empirical tests or whether it is not the sort of thing for which testing would be relevant?

Shiller
What comes to my mind is that rational expectations models have to assume away the problem of regime change, and that makes them hard to apply. It’s the same criticism they make of Kahnemann and Tversky, that the model isn’t clear and crisp about exactly how you should apply it. Well, the same is true for rational expectations models. And there’s a new strand of thought that’s getting impetus lately, that the failure to predict this crisis was a failure to understand regime changes. The title of a recent book by Carmen Reinhart and Ken Rogoff—the title of the book is This Time Is Different—to me invokes this problem of regime change, that people don’t know when there’s a regime change, and they may assume regime changes too often—that’s a behavioral bias [Carmen Reinhart and Kenneth Rogoff (2009)]. I don’t know how we’re going to model that. Reinhart and Rogoff haven’t come forth with any new answers, but that’s what comes to my mind now, at this point in history. And I don’t know whether you can comment on it: how do we handle the regime change problem? If you don’t have data on subprime mortgages then you build a model that doesn’t have subprime mortgages in it. Also, it doesn’t have the shadow banking sector in it either. Omitting key variables because we don’t have the data history on them creates a fundamental problem That’s why many nice concepts don’t find their way into empirical models and are not used more. They remain just a conceptual model.

Hoover
Bob, do you want to . . . or Dale. . . .

Mortensen
More as a theorist, I am sensitive to that problem. That is the issue. If the world were stable, then rational expectations means simply agents learning about their environment and applying what they learned to their decisions. If the environment’s simple, then how else would you structure the model? It’s precisely—if you like, call it “regime change”—what do you do with unanticipated events? More generally—regime changes is only one of them—you were talking about institutional change that was or wasn’t anticipated. As a theorist, I don’t know how to handle that.

Hoover
Bob, did you want to comment on that? You’re looking unhappy, I thought.

Lucas
No. I mean, you can’t read Muth’s paper as some recipe for cranking out true theories about everything under the sun—we don’t have a recipe like that. My paper on expectations and the neutrality of money was an attempt to get a positive theory about what observations we call a Phillips curve. Basically it didn’t work. After several years, trying to push that model in a direction of being more operational, it didn’t seem to explain it. So we had what we call price stickiness, which seems to be central to the way the system works. I thought my model was going to explain price stickiness, and it didn’t. So we’re still working on it; somebody’s working on it. I don’t think we have a satisfactory solution to that problem, but I don’t think that’s a cloud over Muth’s work. If Jack thinks it is, I don’t agree with him. Mike cites some data that Jack couldn’t make sense out of using rational expectations. . . . There’re a lot of bad models out there. I authored my share, and I don’t see how that affects a lot of things we’ve been talking about earlier on about the value of Muth’s contribution.

Young
Just to wrap up the issue of possible alternatives to rational expectations or complements to rational expectations. Does behavioral economics or psychology in general provide a useful and viable alternative to rational expectations, with the emphasis on “useful”?

Shiller
Well, that’s the criticism of behavioral economics, that it doesn’t provide elegant models. If you read Kahnemann and Tversky, they say that preferences have a kink in them, and that kink moves around depending on framing. But framing is hard to pin down. So we don’t have any elegant behavioral economics models. The job isn’t done, and economists have to read widely and think about these issues. I am sorry, I don’t have a good answer. My opinion is that behavioral economics has to be on the reading list. Ultimately, the whole rationality assumption is another thing; it’s interesting to look back on the history of it. Back at the turn of the century—around 1900—when utility-maximizing economic theory was being discovered, it was described as a psychological theory—did you know that, that utility maximization was a psychological theory? There was a philosopher in 1916—I remember reading, in the Quarterly Journal of Economics —who said that the economics profession is getting steadily more psychological. {laughter} And what did he mean? He said that economists are putting people at the center of the economy, and they’re realizing that people have purposes and they have objectives and they have trade-offs. It is not just that I want something, I’ll consider different combinations and I’ll tell you what I like about that. And he’s saying that before this happened, economists weren’t psychological; they believed in such things as gold or venerable institutions, and they didn’t talk about people. Now the whole economics profession is focused on people. And he said that this is a long-term trend in economics. And it is a long-term trend, so the expected utility theory is a psychological theory, and it reflects some important insights about people. In a sense, that’s all we have, behavioral economics; and it’s just that we are continuing to develop and to pursue it. The idea about rational expectations, again, reflects insights about people—that if you show people recurring patterns in the data, they can actually process it—a little bit like an ARIMA model—and they can start using some kind of brain faculties that we do not fully comprehend. They can forecast—it’s an intuitive thing that evolved and it’s in our psychology. So, I don’t think that there’s a conflict between behavioral economics and classical economics. It’s all something that will evolve responding to each other—psychology and economics.

Lucas
I totally disagree.

Mortensen
I think that we’ve come back around the circle—back to Carnegie again. I was a student of Simon and [Richard] March and [James] Cyert—in fact, I was even a research assistant on A Behavioral Theory of the Firm [Cyert and March (1963)]. So we talked about that in those days too. I am much less up on modern behavioral economics. However, I think what you are referring to are those aspects of psychology that illustrate the limits, if you like, of perception and, say, cognitive ability. Well, Simon did talk about that too—he didn’t use those precise words. What I do see on the question of expectations—right down the hall from me—is my colleague Chuck Manksi [Charles Manksi] and a group of people that he’s associated with. They’re trying to deal with expectations of ordinary people. For a lot of what we are talking about in macroeconomics, we’re thinking of decision-makers sure that they have all the appropriate data and have a sophisticated view about that data. You can’t carry that model of the decision-maker over to many household decisions. And what’s coming out of this new empirical research on expectations is precisely that: how do people think about the uncertainties that go into deciding about what their pension plan is going to look like. I think that those are real issues, where behavioral economics, in that sense, can make a very big contribution to what the rest of us do.

Lucas
One thing economics tries to do is to make predictions about the way large groups of people, say, 280 million people are going to respond if you change something in the tax structure, something in the inflation rate, or whatever. Now, human beings are hugely interesting creatures; so neurophysiology is exciting, cognitive psychology is interesting—I’m still into Freudian psychology—there are lots of different ways to look at individual people and lots of aspects of individual people that are going to be subject to scientific study. Kahnemann and Tversky haven’t even gotten to two people; they can’t even tell us anything interesting about how a couple that’s been married for ten years splits or makes decisions about what city to live in—let alone 250 million. This is like saying that we ought to build it up from knowledge of molecules or—no, that won’t do either, because there are a lot of subatomic particles—we’re not going to build up useful economics in the sense of things that help us think about the policy issues that we should be thinking about starting from individuals and, somehow, building it up from there. Behavioral economics should be on the reading list. I agree with Shiller about that. A well-trained economist or a well-educated person should know something about different ways of looking at human beings. If you are going to go back and look at Herb Simon today, go back and read Models of Man. But to think of it as an alternative to what macroeconomics or public finance people are doing or trying to do . . . there’s a lot of stuff that we’d like to improve—it’s not going to come from behavioral economics. . . at least in my lifetime. {laughter}

Hoover
We have a couple of questions to wrap up the session. Let me give you the next to last one: The Great Recession and the recent financial crisis have been widely viewed in both popular and professional commentary as a challenge to rational expectations and to efficient markets. I really just want to get your comments on that strain of the popular debate that’s been active over the last couple years.

Lucas
If you’re asking me did I predict the failure of Lehmann Brothers or any of the other stuff that happened in 2008, the answer is no.

Hoover
No, I’m not asking you that. I’m asking you whether you accept any of the blame. {laughter} The serious point here is that, if you read the newspapers and political commentary and even if you read commentary among economists, there’s been a lot of talk about whether rational expectations and the efficient-markets hypotheses is where we should locate the analytical problems that made us blind. All I’m asking is what do you think of that?

Lucas
Is that what you get out of Rogoff and Reinhart? You know, people had no trouble having financial meltdowns in their economies before all this stuff we’ve been talking about came on board. We didn’t help, though; there’s no question about that. We may have focused attention on the wrong things; I don’t know.

Shiller
Well, I’ve written several books on that. {laughter} My latest, with George Akerlof, is called Animal Spirits [2009]. And we presented an idea that Bob Lucas probably won’t like. It was something about the Keynesian concept. Another name that’s not been mentioned is John Maynard Keynes. I suspect that he’s not popular with everyone on this panel. Animal Spirits is based on Keynes. He said that animal spirits is a major driver of the economy. To understand Keynes, you have to go back to his 1921 book, Treatise on Probability [Keynes (1921)]. He said—he’s really into almost this regime-change thing that we brought up before—that people don’t have probabilities, except in very narrow, special circumstances. You can think of a coin-toss experiment, and then you know what the probabilities are. But in macroeconomics, it’s always fuzzy. What Keynes said in The General Theory [1936] is that, if people are really thoroughly rational, they would be paralyzed into inaction, because they just don’t know. They don’t know the kind of things that you would need to put into a decision-theory framework. But they do act, and so there is something that drives people—it’s animal spirits. You’re lying in bed in the morning and you could be thinking, “I don’t know what’s going to happen to me today; I could get hit by a truck; I just will stay in bed all day.” But you don’t. So animal spirits is the core of—maybe I’m telling this too bluntly—but it fluctuates. Sometimes it is represented as confidence, but it is not necessarily confidence. It is trust in each other, our sense of whether other people think that we’re moving ahead or . . . something like that. I believe that’s part of what drives the economy. It’s in our book, and it’s not very well modeled yet. But Keynes never wrote his theory down as a model either. He couldn’t do it; he wasn’t ready. These are ideas that, even to this day, are fuzzy. But they have a hold on people. I’m sure that Ben Bernanke and Austin Goolsbee are influenced by John Maynard Keynes, who was absolutely not a rational-expectations theorist. And that’s another strand of thought. In my mind, the strands are not resolved, and they are both important ways of looking at the world.

My latest column in Bloomberg (out today, 15/11/2013) looks a little at the silly pronouncements of some economists (Nobel Prize winners Robert Lucas and Eugene Fama among them) to the effect that "financial crises are by their very nature unpredictable." These are, in my opinion, essentially meaningless statements if at all examined; they're the equivalent of an excuse: "don't blame us economists for not having a clue the whole system was about to explode!" The column argues -- and this is the important point -- that lots of economists haven't taken this easy and shameful way out, but have taken on the hard work of developing ways to measure systemic risks and, we hope, give us a better chance to detect important instabilities and imbalances in financial markets as they emerge. Many have even begun collaborating in their efforts with physicists, engineers and other such types. If they have a little success, then we might then just possibly do something to head off the worst trouble in potential future crises (IF the regulatory system doesn't suffer massive political interference at just the crucial moment, of course, which I recognize is a big IF).

As part of another project, I've been perusing recent efforts to develop various measures of systemic risk, and thought some readers might be interested. I've only started, so this is a very incomplete list, but there's some interesting stuff here:

Isn't it curious that all these people are wasting their time and effort, since we know from just a few seconds' thought that crises are impossible to predict? In fact, doesn't the EMH tell us that? And isn't that sacred principle enough for us to stop all further thought? It's all a mystery to me why these people persist in what they're doing. [Sorry for the funny indent... I can't seem to get rid of it...]

Thursday, November 14, 2013

The above award should be given to University of Oxford economist Simon Wren-Lewis for concocting yet another defense of the indefensible idea of Rational Expectations (RE). Gotta admire his determination. I've written about this idea many times (here and here, for example), and I thought it had died a death, but that was obviously not true. I'm not going to say too much except to note that the strategy of the Wren-Lewis argument is essentially to ask "what are the alternatives to Rational Expectations?," then to mention just one possible alternative that he calls "naive adaptive expectations," and then to go on to criticize this silly alternative as being unrealistic, which it indeed is. But that's no defense of RE.

He doesn't ever address the question of why economists don't use more realistic ways to model how people form their expectations, for example by looking to psychology and experimental studies of how people learn (especially through social interactions and copying behavior). The only defense he offers on that score is to say they don't want too many details because they seek a "simple" way to model expectations so they can solve their favorite macroeconomic models. That fact that this renders such models possibly quite useless and misleading as guides to the real world doesn't seem to give him (or others) pause.

Lars Syll was a target in the Wren-Lewis post and has a nice rejoinder here. In comments, others raised concerns about why Lars didn't mentioned specific alternatives to RE. I added a comment there, which I'll reproduce here:

It seems to me that there are clear alternatives to rational
expectations and I'm not sure why economists seem loath to use then.
Simon Wren-Lewis gives one alternative as naive "adaptive expectations",
but this seems like a straw man. Here people seem to believe more or
less that trends will continue. That is truly naive. Expectations are
important and the psychological literature on learning suggests that
people form them in many ways, with heuristic theories and rules of
thumb, and then adjust their use of these heuristics through experience.
This is the kind of adaptive expectations that ought to be used in
macro models.

From what I have read, however, the vast "learning
literature" in macroeconomics that defenders of RE often refer to really
doesn't go very far in exploring learning. A review I read as recently
as 2009 used learning algorithms which ASSUMED that people already know
the right model of the economy and only need to learn the values of some
parameters. I suspect this is done on purpose so that the learning
process converges to RE -- and an apparent defense of RE is therefore
achieved. But this is only a trick. Use more realistic learning behavior
to model expectations and you find little convergence at all -- just
ongoing learning as the economy itself keeps doing new things in ways
the participants never quite manage to predict.

As Simon
Wren-Lewis himself notes, " it is worth noting that a key organising
device for much of the learning literature is the extent to which
learning converges towards rational expectations." So again, it seems as
if the purpose of the model is to see how we can get the conclusion we
want, not to explore the kinds of things we might actually expect to see
in the world. This is what makes people angry and I think rightfully
about the RE idea. I suspect that REAL reason for this is that, if one
uses more plausible learning behavior (not the silly naive kind of
adaptive expectations), you find that your economy isn't guaranteed to
settle down to any kind of equilibrium, and you can't say anything
honestly about the welfare of any outcomes, and so most of what has been
developed in economics turns out to be pretty useless. Most economists
find that too much to stomach.

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